Tax me if you can: Tackling the extensive margin of informality in Pakistan

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Pakistan, like Mexico, suffers from a distorted tax system replete with special provisions for vested interest groups, often justified on the grounds of equity or redistribution. The result is that the tax collection falls short of what is needed to maintain levels of service provision or meet MDG goals. There is insufficient financing to provide for the infrastructure needs for investment, or even to maintain existing investment, with tax/GDP ratios at 10% or less (as in the Pakistan case).

In most cases, the tax breaks are inadequate in meeting distributional considerations. These provisions, moreover, have deleterious effects on the potential for sustainable or inclusive growth. In previous work, Ahmad and Best (2012) have argued that the tax system should be simplified, and as far as possible, the distributional considerations determined jointly with tax reforms through public spending and effective social programs.

The Pakistan government has recently attempted to address the issue the falling tax/GDP ratio by focusing on tax cheats with the use of third party information, albeit together with an amnesty. Ahmad, Best and Pöschl use variation in tax status between Mexican firms and variation in the tax rate between different regions within Mexico to investigate the interaction effects between different taxes that firms face.

Firms’ reported profits for one tax, the corporate income tax (CIT), depend on the tax status for its inputs and outputs of another tax, the Value-Added Tax (VAT). In other words, VAT exemptions do not only lead to evasion of VAT; they also lead to greater evasion of the CIT, thereby exacerbating the loss of revenues caused by the exemptions.

Juxtaposing results from a dataset from Mexico’s Tax Administration with Economic Census data shows that misreporting to the tax agency is particularly high when tax exemptions are present. The researchers place the results within the broader framework of the tax reform agenda in Mexico that involves decisions affecting states and households in different circumstances as well as investment decisions.

These results have implications for other developing countries that have growing informality and tax evasion, as in Pakistan. Short-term fixes, such as amnesties, do not begin to address the underlying incentive difficulties and only serve to make matters worse and should be avoided.